Bank of Canada raises rate to 1.25%, but cautions on NAFTA

The Bank of Canada had a window to raise interest rates and it opted to use it.

Canada’s central bank raised its lending benchmark a quarter point to 1.25 per cent, an historically low setting that nonetheless will seem high to anyone who got used to post-crisis borrowing costs that were closer to zero.

“Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity,” the Bank of Canada said in a statement summarizing its latest round of policy deliberations.

In mid-December, Poloz emphasized that he thought lower borrowing costs could pull more people into the labour market and reverse an extended period of stagnant wage gains. The central bank also said it was wary of U.S. President Donald Trump’s threats to quit the North American Free Trade Agreement and how investors and executives would respond to the regular exchange of threats between the United States and North Korea.

Those factors mean Poloz and his advisers on the Governing Council have set a high bar for interest-rate increases in the near term. To emphasize that point, the central bank followed its positive assessment of the economy with a reminder of its worries about NAFTA, the future of which is “clouding the economic outlook,” policy makers said.

Still, the central bank said last year that interest rates must eventually return to higher levels to keep inflation from running out of control, and that it would lift borrowing costs when data send a clear signal. That standard had been met by the end of December, when the unemployment rate dropped to the lowest level in at least four decades.

“Recent data show that that labour market slack is being absorbed more quickly than anticipated,” the Bank of Canada said.

A recent survey of businesses also showed that executives intend to increase investment over the year ahead, despite uncertainty over trade and stability of the international order. Yet policy makers sense fragility in that sentiment. They said worries over the NAFTA are starting to paralyze decision making, and causing some money that might have been spent in Canada to end up in the United States. As a result, the central bank increased its estimate of how much economic growth will be hurt by trade uncertainty. (The central bank predicts gross domestic product will slow to 2.2 per cent in 2018 and 1.6 per cent in 2019, after expanding 3 per cent last year.)

President Donald Trump’s business tax cuts at the end of 2017 will give companies and investors another reason to choose the U.S. over Canada. The central bank assumes only a “small” benefit for Canada from the tax changes because any increase to demand for exports will be nearly offset by lost investment.

“Underlying fundamentals are strong and would support a more robust growth trajectory were it not for the effects of heightened uncertainty around trade policy and increased incentives to shift investment from Canada to the United States as a result to U.S. tax reforms,” the central bank said its latest quarterly report on the economy.

The closest observers of Canadian monetary policy saw the shift coming, albeit some sooner than others.

By last week, the chief economists at all seven of the country’s biggest were predicting a quarter-point increase. The C.D. Howe Institute’s Monetary Policy Council, a panel of academics and Bay Street analysts, said on Jan. 11 that the central bank should raise interests rates by a quarter point today, and at least twice more before the end of the year. That was a shift. At the end of November, the informal group said the Bank of Canada should wait until the spring of 2018 to raise interest rates, and then add a second quarter-point increase by the end of the year.

Predicting the next increase will be more difficult.

Some forecasters, including economists at Royal Bank of Canada, see three more quarter-point increases this year. That seems aggressive, given the Bank of Canada’s doubts about the ability of Canadian companies to compete with Trump’s America in the short term. Those concerns argue for lower interest rates, at least until the future of NAFTA is resolved.